Case Study: Buy Term & Invest the Difference (BTID)

As mentioned, recent blog posts were inspired by a conversation with a future family member about permanent life insurance. As argued, a downside of a term life policy is that there is no cash value at the expiration of the policy. While that is accurate, the trade-off is that a permanent life policy costs so much more than a term life policy. This significant difference in premiums (monthly payments) presents the opportunity to invest that difference. In today’s post, we take a very close look at the numbers by performing an actual case study for the term versus permanent life debate.

San Diego Life Permanent Life Policy Case Study

There are two strategies being compared. The first strategy is to purchase a permanent life policy. For this case study, I have the fortune of using real data from a San Diego Life permanent life policy quoting benefits for a female non-tobacco user age 43, for $500,000 of coverage. (San Diego Life is not the real name of the company.)

Our second strategy is to “buy term and invest the difference (BTID).” For this comparison, I am using quotes for a term life policy from intelliquote.com. Why this site? It’s the number one result when Googling for a term life quote. (This is not an endorsement for the site.)

Running The Numbers

The data from this specific San Diego Life policy shows an annual premium of $12,000. Alternatively, quotes for a 20 year term life policy providing $500,000 of coverage for a female non-tobacco user age 43 vary from as little as $549 per year, to as much as $4,005 per year.

For the initial comparison, consider the more expensive $4,005 term life premium. The San Diego Life uses an assumed nominal (not counting for inflation) growth rate of 10% annually. For equity, we’ll apply that same rate to the “invest the difference” strategy – but tax dividends annually at the highest marginal rate: 53.7%.

Taxes - Dividends
Federal, Unqualified Dividends	39.6%
Medicare Surtax	3.8%
California Highest Marginal Tax Rate	10.3%
Total Dividend Taxes - Applied Annually	53.7%

 

Further, capital gains will be taxed at 34.1% after 20 years.

Taxes - Capital Gains
Federal	20.0%
Medicare Surtax	3.8%
California Marginal Tax Rate	10.3%
Total Capital Gain Taxes - Applied at Distribution	34.1%

This gives the BTID strategy a return of 6.91% annually, net of taxes. Below is the performance of the two strategies over 20 years.

When it comes to San Diego Life's permanent life policy, reading the fine print matters. San Diego Life’s permanent life insurance policy has a 20% + $25 surrender fee. Over 20 years, that’s the difference between a capped maximum of $250,000 for the permanent life policy against the after-tax value of over $324,000 with a buy-term-and-invest-the-difference (BTID) strategy. That’s a difference of over $74,000.

"... the BTID strategy comes out on top by... $74,478"

Even with taxes eating away at over a quarter of gains, the BTID strategy comes out on top by a large margin - a margin of $74,478. Even ignoring the cap of $250,000 in benefits for the San Diego Life permanent life policy, a quick look at the graph above reveals the rate at which the BTID strategy outpaces the cash value offered by the permanent life policy.

 

Running Better Numbers

Recall that these computations were performed assuming a term life policy with an annual premium of over $4,000. That’s an unusually high premium. A more likely scenario is a policy premium of around $500, with (qualified) dividends and capital gains being taxed at just 15%. Given this more realistic scenario, the 20 year difference in a permanent vs. BTID strategy is over $380,000.

Why the startling difference in returns? Consider that in the first year of this permanent life policy, there is no cash (surrender) value. Why? Because that money goes to pay for agent commissions. Further, each year (after the first), the permanent life policy adds around $6,000 in principal. This is roughly half of the annual premium. In contrast, the BTID strategy contributes over $11,000 each year. That's the savings available (for investment) when purchasing a term life policy over a permanent life policy.

Simple math dictates higher returns in the absence of a middleman.

Conclusion

For certain high net worth individuals, a permanent life policy provides particular  tax advantages for estate purposes. However, if your net worth is less than $10.5 million, the case study above of an actual San Diego Life permanent life policy proves BTID as the more lucrative investment strategy. Proponents of permanent life argue the value of the forced savings aspect. However, savings/investing can be easily automated - requiring no additional effort on the part of the individual beyond the initial set up. See below.

Given the data provided by this actual case study of a San Diego Life permanent life policy, it is not surprising that many financial planners advocate for clients to buy a term life policy, and then invest that difference themselves (BTID). If you’re unsure of how to do just that, you can speak with a fee-only financial planner (and not a commission-based  financial salesman) about setting up automatic withdrawals from your checking account to invest in a low-cost target date fund.

Eating Away at Donuts, or Why Putting Cash under the Mattress is a Bad Idea

Saving money is great. It can provide a solution in the event of unforeseen expenses. (It’s good to have some money saved up when your car breaks down.) Saving money can also provide for realizing a goal, like a down payment on a house, or income in retirement. Few can argue that savings money is a wonderful thing.

But, it’s not just about savings money, but how you save it. Savings cash is great. Cash is the most liquid (easily accessible) form of savings. Cash's liquidity is in contrast to stocks or other assets, which must first be sold for cash. Further, cash's value does not fluctuate (in the short term). This is unlike the value of stocks, which increase or decrease in price by the second.

Inflation

Unfortunately, the value of cash erodes rather consistently over the long term because of inflation. Inflation is the effect of government printing money on an ongoing basis. The law of supply and demand dictate that when more of something is available for a given (i.e. stable) demand, that value of thing decreases. Money is no exception. All else being equal, if the money supply increases, the value of money decreases.

"...the cash in your wallet decreases in value consistently over time."

Inflation makes the cash in your wallet decrease in value consistently over time. Longer timelines mean an even greater decrease in the purchasing power of your money. Inflation eats away at purchasing power, which is essentially how much stuff your money can buy. Consider an example:

It’s the year 2013 and $10 can buy a baker’s dozen (13) of tasty donuts. Next year (2014), inflation has eroded the value of the dollar, and $10 now only nets you a straight dozen donuts. The following year, your $10 only gets you 10 donuts, and on it goes.

Thanks to SOMMAI, Grant Cochrane and freedigitalphotos.net for the donut photos.

Inflation is the reason why investing your money – and not stuffing it under the mattress – is important. Money in your mattress does not increase with time. In order to preserve the value (purchasing power) of your money, you need to invest it.

Investing Your Money

The easiest – and safest – way to invest your money is by putting that money into an FDIC-insured savings account. For a little less liquidity (access to your money), Certificates of Deposit (CD) offer a higher yield – or a higher return/rate of growth on your investment. Most banks or credit unions offer FIDC-insured CDs. Government bonds offer similar safety, but even less liquidity. You can buy government bonds directly via TreasureyDirect.gov. By using TreasueryDirect.gov, you avoid any middle man who will take a cut of your yield.

Know that yields on savings accounts, CDs, or government bonds may – or may not – keep up with inflation. (Such is the case in today's low interest rate environment). In fact, sometimes even riskier, higher-yielding investments may not even keep up with inflation. The 1970s was an example of this; stock market returns were flat while inflation was in the double digits.

"...putting your money into a savings account or other investment will help the value of your savings keep up with inflation."

Proponents of the mattress strategy and critics of the above investment strategy may reference Cyprus's recent tax on existing assets. And while it is possible that the United States government may make such a move to balance its out-of-control budget, it is highly unlikely. On the other hand, the chance that the value of one's money will erode with inflation is guaranteed.

In short, putting your money into a savings account or other investment will help the value of your savings keep up with inflation. This way, inflation won’t eat away at the value of your money. Instead, saving appropriately will ensure that you get to eat away at donuts.

Some Basics

Consider these basic first steps to help you achieve your financial goals.

Build an Emergency Fund

Unexpected expenses may pop up at moment’s notice. Your car may break down, or you may require an expensive dental procedure. By keeping a cash reserve, you can tap this money without having to put the unanticipated expense onto a high-interest rate credit card. Popular media suggests between three and six months of expenses as a sufficient amount of savings.

"Imagine ... rapidly paying down debt. Now, you have an unanticipated expense... that must go onto the credit card."

Keep this money liquid; it should go into a savings account. If you're looking for a slightly larger return on your cash (and can handle a little bit of inconvenience), consider a Certificate of Deposit (CD) or a CD ladder. Do not put this money into a risky investment – like stocks (or dare I even say, "bonds").

 

Quickly Pay Down Debt

Once you have built up an emergency fund, redirect that extra monthly savings to quickly pay down debt. You want to establish the emergency fund first, and then quickly pay down debt. Why? Imagine the following scenario: 

You are rapidly paying down debt. Now, you have an unanticipated expense - and you do not have an emergency fund to tap. That surprise expense must go onto the credit card – which means more debt! Had you established an emergency fund first, you could take that emergency fund money to pay for the surprise expense.

Health Insurance

For some, employers already provide health insurance. For everyone else, read on:

For young, healthy folks, a high-deductible plan may be the best way to go. A high-deductible plan keeps premiums (monthly payments to the insurance company) low. The trade-off is that a high deductible plan only kicks-in at certain thresholds. That is, you have to spend several thousand dollars of your own money before the insurance company starts to pay the bills. A high-deductible plan works best for really expensive catastrophic events: like a severe injury from an auto accident, or cancer. A high-deductible plan is not as cost efficient for those clients seeing a doctor regularly. 

Also, some high-deductible plans allow for the creation of a Health Savings Account (HSA). An HSA is a tax-deductible investment account, with investment proceeds paying for qualified medical expenses tax-free. While that last line may sound complicated, it essentially says that there are particular tax-advantages with using an HSA. In the end, that means paying less for your medical bills.

For older individuals or those with health issues, consider a more comprehensive Preferred Provider Organization (PPO) plan.

"Just like a cash reserve helps stave off debt in the instance of moderate, unanticipated expenses, health insurance protects individuals from massive, unanticipated health-related expenses." 

Why even bother getting health insurance? Imagine working hard to save up an emergency account and paying down all your debt. Now, something happens that costs a lot of money – like a car accident that causes a severe injury. If something like that happened, consider your emergency fund gone and your debt ramped all the way back up. Just like a cash reserve helps stave off debt in the instance of moderate, unanticipated expenses, health insurance protects individuals from massive, unanticipated health-related expenses.

Renter’s Insurance

You may have accumulated some nice stuff over the years: a big flat-screen, a huge leather sectional, a carbon fiber bicycle, your engagement ring. Renter’s insurance can protect those assets in event of fire, theft, or other variables. Much more importantly, if someone is injured during an accident in your home, renters insurance will help protect you in the case of a liability lawsuit. Potential lawsuits can make up a tidy sum – more than all those valuables you accumulated many times over.

Umbrella Policy

An umbrella policy picks up where your auto and renter’s insurance leaves off, increasing the amount for which you are covered under both policies. One suggestion is to attain coverage for $1 million.  Fortunately, such high coverage is relatively inexpensive, and can be for less than $20 a month. 

"...money you have not even yet earned can be taken away from you. There is where an umbrella policy steps in to protect you."

Some make the case that you only need to insurance yourself for up to your net worth – the total value of how much money and other valuable stuff (car, home equity, etc.) you own. However, there are instances where future wages can be garnished in a lawsuit. Said another way, money you have not even yet earned can be taken away from you. There is where an umbrella policy steps in to protect you.

Umbrella policies are relatively simple to understand and purchase because there are few variables involved. This is in stark contrast to:

Disability Insurance

Many individuals mistakenly think that their house, their car or their retirement portfolio is their most valuable asset. In most instances, one’s most valuable asset is themselves – and their future earning power. That is, while your car may be worth $20,000, this is nothing in comparison to the wages that you will earn during the rest of your working career. You can insure this asset – your future income – with disability insurance. Disability insurance steps in when you are no longer employable.

"...disability insurance makes sense to cover living expenses not covered by Social Security and employer benefits combined."

Note that some employers already provide some level of disability insurance. Further, Social Security also provides some disability benefit payments too. The hard work comes from doing the math: how much in Social Security benefits do you qualify for? How long will employer benefits make payments for? When determining just how much (or how little) disability benefits an individual is eligible for, disability insurance begins to makes sense. This is because living expenses may exceed Social Security and employer benefits combined.

Retirement Savings

Once you’ve tackled the above, consider saving for retirement. (You can also attack these projects, and retirement savings, simultaneously.) Not sure how to get started on retirement investing? Consider either a simpler or more involved option for investing.

Long-Term United States Treasuries Are Awesome

In previous posts, I discussed the negative correlation of long-term United States Treasuries, and how they can add value to your portfolio via diversification.

Today’s post is inspired by stock market returns at the moment – where United States long-term Treasuries are up and everything else is down. Take a look below:

Most asset classes are having a bad day. From domestic large value to international real estate, returns are in the red. The exceptions are those funds holding United States long-term Treasuries, which are in the green. This is the negative correlation of long-term United States Treasuries manifested, and the reason why this asset class deserves a place in your diversified portfolio. 

Note that both long-term Treasuries and United States Inflation Protected Securities (TIPS) are up. Certain tips funds, the Schwab TIPS fund as an example, holds a portion of inflation-linked bonds with maturities of 10 years or greater. As of this writing, that portion is around 26%. Vanguard’s Long Term Treasury ETF VGLT, however, holds only bonds with maturities in excess of 10 years.

Were trading commissions and bid/ask spreads not an issue, an investor could even seize this opportunity to rebalance their portfolio: selling high and buying low. (Yale University's endowment actually rebalances certain portions of their portfolio daily.) Alas, such fees – whether divulged (trading commission) or concealed (bid/ask spreads) – do exist. Thus, only occasional rebalancing is suggested.

So while the high duration of a long-term United States bond may scare you away in today’s low interest rate environment, consider that long-term government bonds offer value in addition to their now-small coupon payments. Long-term Treasuries can act as a powerful diversifier in your well-diversified portfolio.